Grey Owl Capital: A Quick Review of the Past 7 Years

In Grey Owl Capital Management latest quarterly letter, after commenting on the perceived importance of GDP forecasting (and the lack of accuracy therein), they unravel the 2014 GDP figures released year-to-date. Our analysis convinces us that investing in anything other than an “all-weather” portfolio is foolhardy. We also discuss recent portfolio adjustments and provide a more in-depth discussion of eBay Inc (NASDAQ:EBAY) – a rare secular growth story in a low-growth environment.

Additionally, you can find our latest performance information, along with relevant disclosure, on our website. Since inception on 10/31/06, the Grey Owl Opportunity Strategy has returned 63.83% cumulative and net of fees compared to 66.97% for the SPDR S&P 500 ETF Trust (NYSEARCA:SPY).

Grey Owl Capital Management Q2 Letter

July 31, 2014

“Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.”

– Bank for International Settlements, 84th Annual Report, June 2014

Dear Client,

Even after a second quarter rebound, gross domestic product (GDP) growth is barely positive for the first half of 2014. That has not stopped the S&P 500 from climbing to new highs. In fact, GDP growth has been weak for the entire “recovery” and, while improved, corporate sales and earnings also leave something to be desired. Stock market returns look better still, but only when compared to these weak results. Looking over a longer timeframe, the US equity market is approaching fifteen years of low single-digit returns.

Despite the unfriendly environment, US entrepreneurship remains strong and there are pockets of very robust secular growth. We even think there are a few bargains to be found in an equity market at all-time highs. We discuss those topics, as well as the challenge of GDP forecasting, signs of trouble in securities markets, and portfolio adjustments below.

A Quick Review of the Past (Almost) Seven Years

The Bank for International Settlements (BIS) recently weighed in on the state of the global economy, markets, and central bank intervention. The organization published its 84th Annual Report2 in June.

The report is relatively informative, grounded in sober reality, and presented in a straightforward manner (unlike much of the commentary out of the US Federal Reserve which can be incredibly difficult to parse). A few quotes from the overview sum up the report and largely match our view of the world. The emphasis is ours.

“The global economy has shown encouraging signs over the past year. But its malaise persists, as the legacy of the Great Financial Crisis and the forces that led up to it remain unresolved.”

“By mid-2014, investors again exhibited strong risk-taking in their search for yield: most emerging market economies stabilized, global equity markets reached new highs and credit spreads continued to narrow.”

“Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.”

Within the report, several data points about the US economy are worth highlighting:

US real GDP is up a mere 5.9% from its 2007 peak

US employment level is still lower than the 2007 peak – by -0.8% (Note: this is the number of employed people, NOT the unemployment rate which is more frequently referenced)

Gross debt in the US is up 42% over the same period

From our perspective this paints a pretty clear picture. Despite a significant increase in debt levels, growth has been very slow (more on this later). Because of the significant increase in debt levels, the foundation for future growth is wobbly.

Turning to Howard Silverblatt’s S&P 500 Earnings and Estimate Report, we get a picture of corporate sales and earnings growth. The last cycle peak for per share quarterly earnings occurred in the second quarter of 2007 (at about the same point that GDP peaked). From that quarter through the first quarter of 2014: